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Financial management

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  • 1. Meaning of Ratio and Ratio analysis. Ratio is mathematical yardsticks that measure the relationships between two figures, which are related to each other and mutually inter-dependent. A ratio is simply one number expressed in terms of another number. In other words, a ratio expressed mathematical relationship between one number and another. Ratio analysis is attempted to derive quantitative measures or guides concerning the financial health and profitability of a business enterprise. Ratio analysis can be used both in trend and static analysis. There are several ratios at the disposal of an analyst but the group of ratio he would prefer depends on the purpose and objective of analysis. In simple words a ratio is one figure expressed in terms of another figure. For example the ratio of 200 to 100 is expressed as 2:1 or as 2. Thus a ratio is calculated one figure into another. Example: Gross Profit = Rs. 20,000 Sales = Rs. 1,00,000 Ratio of Gross profit to sales = Gross Profit 20,000 Sales 1,00,000 0.2: 1 or simply as 0.2 Certain ratio between two numbers coveri8ng a definite period of time are expressed as a rate e.g. stock turnover is five times a year. An accounting ratio shows the mathematical relationship between two figure which have meaningful relation with each other e.g. gross profit and sales, net profit and sales, current asset and current liability etc. No useful purpose is served if ration are calculated between two figure, which are not, related at all to each other e.g. purchase and premiums on the issue of the share. There are three forms of ratio- 1) Pure Ratio-This is a simple form of ratio. In this case numerator is divided by denominator. Pure ratio is expressed inform of relationship. For e.g. Ideal current ratio is 2:1. 2) Percentage form- In this case numerator is divided by denominator and multiplied by 100. For e.g. G.P. Ratio is 41%. 3) Rate Form- In this case numerator is divided by denominator; it is followed by the word times. For e.g. Debtors Turnover 4 times. Ratio analysis is the methods or process by which the relationship of items or group of items in financial statements are computed, determined and presented. Ratio analysis is the best-known and most widely used tool of financial analysis. In financial analysis a ratio is used as an index or yardstick for evaluating the financial performance of a firm. The absolute accounting figure contained in the financial statement may not be very meaningful. For example, a profit of Rs. 5,00,000 may look impressive. But the performance of the firm cannot be judged without the comparing this net profit figure with the total amount invested to earn this profit. If this profit of Rs. 5 lakhs has been earned on an investments of Rs/. 1 corer, then the ratio of the net profit to total capital is only 5 lakhs20 lakhs multiply by 100 = 5%, which is not reasonable return on capital employed. Interpretation of RatioInterpretation of Ratio Broadly speaking, ratio may be interpreted in four different ways to follows: An individual's ratio may have significance of its own. For example a ratio of 25% of net profit on capital employed shows a satisfactory returns. DJ Help.ani
  • 2. Ratio may be interpreted by making comparisons over time. For example, ratio of net profit on capital employed is 25%. This ratio may be compared with the similar ratios of a number of past years. Such comparison will indicate the trend of rise, decline or stability of the ratio. Ratios of any one firm may be compared with the ratio of others firms in the same industry. This is known as inter-firm comparison. Such comparison shows the efficiency of a firm as compared to other firms. Ratio may be interpreted by considering a group of several selected ratios. For example, the utility of current ratio is enhanced if it used along with other related ratio like quick ratio or acid test ratio, stock turnover ratio, etc. Similarly various profitability ratios may be considered in relations to each other. CLASSIFICATION OF RATIOCLASSIFICATION OF RATIO Ratio may be classified in a variety of ways. Some of the possible methods are given below: 1) Balance sheet ratio These ratio deals with the relationship between two items appearing in the balance sheet e.g. current ratio, liquid ratio, debt equity ratio etc., 2) Profit and loss ratio: This type of ratio show the relationship between two items which are in the profit and loss account itself, e.g. gross profit ratio, net profit ratio, operating ratio etc. 3) Combined and composite ratio: These ratios show the relationship between items one of which is taken from profit and loss account and the other from the balance sheet e.g. Rate of return on capital employed, debtor turnover ratio, stock turnover ratio etc. Meaning of Current Assets. Current assets includes: a) Cash in Hand and at bank. (b) Readily marketable securities (c) Bill Receivable (d) Debtor less provision for bad and doubtful debts (e) Stock in trade (f) Prepaid Expenses (g) Any other asset, which in the normal courses of business, will be converted in cash in year's time. Meaning of Current liability. These include all obligations maturing within a year such as: (a) Sundry creditors (b) Bills payable (c) Bank overdraft (d) Income Tax Payable (e) Dividend Payable (f) Outstanding expenses (g) Provision for taxation Significance and objectives: Current ration throws good light on the short-term financial positions and policy. It is an indicator of a firm's ability to promptly meet its short-term liabilities. On the other hand a relatively low current ratio indicates that the firm will find it difficult to pays its bills. Normally a current ratio of 2:1 is considered satisfactory In other words current assets should be twice the amount of current liabilities If the current ratio is 1:1 it means that the funds yielded by current assets are just sufficient to pay the amount due to various creditors and there will be nothing left to meet the expenses which are being currently incurred. Thus the ratio should always be more than 1:1 A very high current ratio is also not desirable because it indicates idleness of funds which is not a sign of efficient financial management. (A) BALANCE SHEET / FINANCIAL POSITION RATIOS 1) Current Ratio-
  • 3. Current ratio is also known as “working capital ratio’ or “solvency ratio” or “2:1” Ratio. This ratio expresses the relationship between current assets and current liabilities. Current Ratio = Current Assets Current Liabilities Purpose: The main purpose of this ratio is to determine a short-term financial strength of the company. 2) Liquid Ratio / Near Money Ratio- Liquid ratio is also known as “Quick Ratio” or “Acid Test Ratio” or “1:1” Ratio. This indicates the liquid financial position of an organization. This ratio shows the ability to meet its immediate liabilities. It measures the relationship between quick assets and quick liabilities. Quick / Liquid Ratio = Quick Assets Quick liabilities • Quick Assets = Current Assets – Stock – Prepaid Expenses – Advances • Quick Liabilities = Current Liabilities – Bank Overdraft Meaning of quick assets and quick liabilities The quick assets include cash, debtors (excluding bad debts) and securities, which can be realized without difficulty. Stock is not included in quick assets for the purpose of this ratio. Similarly prepaid expenses are also Excluded, as they cannot be converted into cash. Liquid or quick liabilities refer to all current liabilities except bank overdraft. Significance and objective. Quick ratio is a more rigorous test of liquidity of a firm than the current ratio. When quick ratio is used along with current ratio, it gives a better picture of the firm’s ability to meet its short-term liabilities out of its short-term assets. This ratio is of great importance for banks and financial institutions. Generally a quick ratio of 1:1 is considered to represent a satisfactory current financial position. Purpose: The purpose of liquid ratio is to measure the immediate solvency of the business and indicate the availability of cash to meet its immediate liabilities. 3) Proprietary Ratio- Proprietary Ratio is a test of the financial and credit strength of the business. It is related with shareholders funds and total assets. This ratio determines the long term or ultimate solvency of the business. It is also called “Net Worth to Total Assets Ratio” or “Equity Ratio” or “Assets Backing Ratio” or “Net Worth Ratio"
  • 4. Shareholders funds comprise of ordinary share capital, preference share capital and all items of reserves and surplus. Total assets include all tangible assets and only those intangible assets which have a definite realizable value. Proprietary Ratio = Proprietors Funds x 100 Total Assets Proprietors Fund = Equity Share Capital + Pref. Capital + Capital Reserve + Rev. Res. – Fictitious Assets Total Assets = All Fixed Assets + All Current Assets + Investments. OR PROPRIETARY RATIO = Proprietors’ Funds x 100 Total Funds Total Funds = Owned Funds + borrowed Funds Significance and Objectives Proprietary ratio shows the extent to which shareholders own the business and thus indicates the general financial strength of the business. The higher the proprietary ratio, the greater the long term stability of the company and consequently greater protection to creditors. However, a very high proprietary ratio may not necessarily be good because if funds of outsiders are not used for long term financing, a firm may not be able to take advantage of trading equity. 4) Stock- Working Capital Ratio- Stock Working Capital Ratio brings out the relationship between stock and working capital. It is also known as “Inventory Net Current Assets Ratio”. Stock Working Capital Ratio = Stock x 100 Working Capital This ratio is calculated in percentage form. The standard ratio is “Less than 100%”. The purpose of this ratio is to show the extend to which working capital is blocked in inventories. • Working Capital = Current Assets – Current Liabilities 5) Capital Gearing Ratio-
  • 5. Capital Gearing Ratio brings out the relationship between two types of capital, which are capital carry fixed rate of interest, & capital that does not carry fixed rate of interest. This ratio is also known as “Leverage Ratio” or “Capital Structure Ratio”. Capital Gearing Ratio = Capital Carrying Fixed Rate of Interest / Dividend Capital Not carrying Fixed Rate Of Interest / Dividend • Capital carrying fixed rate of interest includes preference share capital + debentures + bank loan + Bonds. A company is said to low geared when its fixed assets bearing securities are lesser than equity shareholders funds. Te purpose of this ratio is to see the capital structure of the company effectively. 6) Debt – Equity Ratio – It expresses the relationship between long-term debt and total funds. This ratio shows long-term capital structure. Debt Equity Ratio = Long Term Debts OR Long Term Debts Total Funds Eq. Share Funds Note – Long-term debts include redeemable preference shares also. • Total Funds = Shareholders’ Funds + long Term Liability Sometimes this ratio is expressed in percentage form. (B) OPERATING / REVENUE STATEMENTRATIO/ PROFITABILITY 1) Gross Profit Ratio- Gross profit ratio brings out the relationship between gross profit and net sales. It is also know as “Turnover Ratio” or “Gross Margin Ratio” It is expressed as a percentage of net sales. Gross Profit Ratio indicates the basic profitability of the business. Gross Profit Ratio = Gross Profit x 100 Net Sales Equations- 1) Gross Profit = Net Sales – Cost of goods sold 2) Net Sales = Gross Sales + Credit Sales 3) Gross Sales = Cash Sales = Credit Sales 4) Cost of Goods Sold = Opening Stock = Purchase = Direct Expenses – Purchases Returns – Closing Stock.
  • 6. A low gross profit ratio indicates inefficiency of purchase department, increased expenses or inability to increase sales. A high gross profit ratio indicates the efficiency of sales department, purchase department and effective control over expenses. Significance: Gross profit ratio indicates the average margin on the goods sold. It shows whether the selling prices are adequate or not. It also indicate the extent to which selling price may be reduced without resulting in losses. A low gross profit ratio may indicate a higher cost of goods sold due to higher cost of production. It may also be due to low selling price. 2) Operating Ratio- operating ratio brings out the relationship between total operating cost and net sales. This is expressed as percentage. Operating Ratio = Operating cost x 100 Net Sales Operating Cost = Cost of goods Sold + Office Administrative Expenses + Selling & Distribution Expenses + Finance Expenses + Amortisation. The purpose of operating ratio is to ascertain the efficiency of the management with regard to the business operations. A low operating ratio shows the better operating efficiency of the business. A high operating ratio shows the lower profits, which is not favorable for business. Hence, inefficiency of the management. 3) Expenses Ratio:- The ratio of each items expense to net sales is known as an "Expenses Ratio" and such ratio are collectively known as "Expenses Ratios" These are as under- 1) Cost of goods sold ratio= Cost of goods sold x 100 Net sales 2) Office & Administrative Exp. Ratio= Office & Admn. Exp. x 100 Net Sales 3) Selling & Distribution Exp. Ratio= Selling & Dist. Exp. x 100 Net sales 4) Finance Expenses Ratio= Finance Expenses x 100 Net Sales
  • 7. Expenses ratio brings out the relationship between various elements of operating cost and net sales. Significance & Objectives- The operating ratio is the yardstick to measure the efficiency with which a business is operated. It shows the percentage of net sales that is absorbed by cost of goods sold and operating expenses. A high operating ratio is considered unfavorable because it leaves a smaller margin of profit to meet non-operating expenses. On the other hand a lower operating ratio is considered a good sign. 4) Net Profit Ratio: - Net profit ratio indicates the relationship between net profit and net sales. Net profit can be either operating net profit or net profit before tax or net profit after tax. This ratio is also known as "Net margin on sales ratio" Net Profit Before Tax ratio = Net Profit Before Tax x 100 Net sales Net Profit after Tax Ratio= Net profit After Tax x 100 Net Sales Significance & Objective: The net profit ratio is the overall measure of a firm's ability turns each rupee of sale into profit. It indicates the efficiency with which a business is managed. A firm with a high net profit ratio is in as advantageous position to survive in the face of rising cost of production and falling selling price. 5) Net operating Profit Ratio: Net operating profit ratio is also known as "Operating profit ratio" This ratio established the relationship between net operating profit and net sales, which is expressed in percentage. Net Operating Profit Ratio = Net Operating Profit x 100 Net Sales 6) Stock -Turnover Ratio Stock turnover ratio is also known as "Inventory Turnover Ratio" or Stock Velocity Ratio" This ratio Measure the number of times stock rotate or turns or flows in an accounting year. Stock-Turnover Ratio = Cost of Goods Sold Average Stock
  • 8. The ratio indicates the relationship between inventory and cost of goods sold. It is expressed in number of times in a year. Average Stock = Opening Stock + Closing Stock 2 Significance and Objectives Inventory or Stock Turnover Ratio indicates the efficiency of a firm’s inventory management. This ratio gives the rate at which stocks are converted into sales and then into cash. A low inventory turnover ratio is an indicator of dull business, accumulation of inventory, over investment in inventory or unsaleable goods etc. generally speaking, a high stock turnover ratio is considered better as it indicates that more sales are being produced by each rupee of investment in stock but a higher stock turnover ratio may not always be an indicator of favorable results. It may be the result of a very low level of stock which results in frequent out of stock positions. Such a situations prevents a company from meeting customer’s demands and the company cannot earn maximum profits. Thus too high and too low inventory turnover ratio may not be good and should be investigated further. A company should have a proper inventory turnover ratio so that it is able to earn a reasonable margin of profit. Note: If in the problem Opening Stock is not given then closing stock figure is considered as Average stock.